Wednesday, May 29, 2013

I respond to readers’
questions regarding the DOL/EBSA’s re-proposed “Definition of Fiduciary” Rule.

Table Of Contents

(1) “Ron, when will the DOL’s re-proposed rule be
available to see? And when would it be finalized?”

(2) Will the DOL’s Rule Only Apply to Individuals (Not
BD Firms)?

(3) Will Proprietary Products Be Available Under the
DOL’s Re-Proposed Rule?

(4) Will ERISA’s Standards Now Apply to IRAs and to
the IRA Rollover Decision?

(5) Specifically, How Will the EBSA’s Re-Proposed Rule
Expand the Definition of “Fiduciary”?

(6) Will There Be Any Exemptions Provided from the
Expanded Definition of Fiduciary?

(7) What Should Plan Sponsors Do Now?

Introduction

As many readers are aware,
the U.S. Department of Labor’s (DOL’s) Employee Benefits Security
Administration (EBSA) is likely to re-promulgate, later this year, its proposed
expansion of the “Definition of Fiduciary.” Under current regulations many of
those who provide advice relating to investment selection to plan sponsors are
not considered fiduciaries. Under the new regulations two major changes are
anticipated:

First,
nearly everyone who provides investment advice to ERISA-covered plan sponsors
(and to plan participants) would be considered a fiduciary.

Second,
those providing investment advice to IRA account holders would also be
considered fiduciaries.

As I’ve previously written,
these rules – if finalized by DOL/EBSA – are likely to be “game-changers”
within the financial services industry. Current ERISA regulations, with their
pre-emptive nature, prevents the application of common law fiduciary status to
many who provide advice on investments to plan sponsors. As a result, many
current advisors to defined contribution plan accounts are not fiduciaries
under the law. Also, with the inclusion of IRA accounts, and the IRA
distribution decision, many more “financial advisors” will be considered
fiduciaries, at least respect to such accounts. According to the Investment
Company Institute, at the end of 2012:

The
largest components of retirement assets were IRAs and employer-sponsored DC
plans, holding $5.4 trillion and $5.1 trillion, respectively, at year-end 2012.
Other employer-sponsored pensions include private-sector DB pension funds ($2.6
trillion), state and local government employee retirement plans ($3.2
trillion), and federal government plans—which include both federal employees’
DB plans and the Thrift Savings Plan ($1.6 trillion).

While not all of the
foregoing accounts are governed by ERISA’s rules, approximately $15 trillion
dollars (or more) of retirement accounts would be subject to the new
“Definition of Fiduciary” rules. This is a significant portion of the overall
capital markets.

For example, “the sum of the
market-cap of the NYSE, NASDAQ and AMEX on Bloomberg today (04-02-2012) is
$21.4 Trillion — pretty close numbers for the kind of data gathering these
summaries involve. Going with the SIFMA and Bloomberg numbers, the US capital
market is about $58.4 Trillion, consisting of 63.4% bonds and 36.6% stocks.”
QVM Group, LLC, “World Capital Markets – Size of Global Stock and Bond Markets,”
Perspectives, April 2, 2012),
available at http://qvmgroup.com/invest/2012/04/02/world-capital-markets-size-of-global-stock-and-bond-markets/.

I’ve received several
questions from readers regarding the EBSA’s re-proposed rule, believed to be
re-promulgated by EBSA later this year. Here are my replies thereto.

(1) “Ron, when will the DOL’s re-proposed
rule be available to see? And when would it be finalized?”

The re-proposed rule must
first be submitted by DOL/EBSA to the Office of Management and Budget. At that
point it would go through a 90-day review process. Only with OMB’s approval
would the re-proposed rule be released for all to see.

It is not certain that the
re-proposed rule will be released to OMB, nor that it survives OMB scrutiny.
Why? First, there is tremendous opposition from the wirehouses and insurance
companies to the rule, and they are flooding Congress with lobbying in
opposition to the rule ever seeing the light of day. They are also extensively
lobbying OMB to not permit the rule’s release. In addition, a new U.S.
Secretary of Labor needs to be confirmed, and when confirmed that person is
likely also likely to be lobbied extensively. While Asst. Secretary Phyllis
Borzi remains, by all accounts, committed to re-proposing the rule, I would not
be totally surprised if lobbying by Wall Street firm and the insurance lobby
stops the rule from ever seeing the light of day.

When the re-proposed rule is
released, there is likely to be a long comment period – perhaps 3-4 months (or
even longer). Thereafter, the EBSA must consider all of the comments prior to
finalizing the rule. During this time lobbying against the rule will again be
heavy, in an attempt to get the DOL/EBSA to withdraw the rule or delay the
process.

My current guess is that the re-proposed rule would
be released by October or November of this year, although that timeline could
be delayed. It would then likely take another year before any rule is finalized,
given the necessity to review all of the hundreds (if not thousands) of
comments likely to be submitted.

Having said that, be aware
that delays in agency rule-making occur frequently. And, as stated above, given
the tremendous opposition to this rule from some sectors, it is altogether far
from certain that a re-proposed “Definition of Fiduciary” rule will ever be
released, much less finalized and enacted.

(2) Will the DOL’s Rule Only Apply to
Individuals?A reader asks: “Under the DOL’s proposal, will the fiduciary obligation
fall only on the individual financial advisor, or does it also apply to their
associated broker-dealer as well? More specifically, if a financial advisor
works for a large broker-dealer, and the broker-dealer has a fixed compensation
model for financial advisors (to comply with the newly proposed fiduciary
guidelines), would the broker-dealer be able to maintain revenue-sharing
arrangements with the asset manager? If not, why not?”

Yes, a broker-dealer firm is liable,
in most instances, for a breach of fiduciary duty by its registered
representative. This is because, under general principles of law, employers are
vicariously liable, under the respondeat
superior doctrine, for the acts or omissions by their employees in the
course of employment (sometimes referred to as “scope of employment”). For an
act to be considered within the course of employment it must either be
authorized or be so connected with an authorized act that it can be considered
a mode, though an improper mode, of performing it.

The delivery of “advice” –
which leads to the imposition of fiduciary status – results from actions
undertaken by the registered representative in furtherance of the objectives of
the firm. Hence, under ERISA, it is clear that (in nearly all cases) both the firm
and the individual advisor possess the fiduciary duty to the client.

But wait, you say … how can a
registered representative owe a fiduciary duty to a client, when the registered
representative also owes a fiduciary duty to the broker-dealer firm (as the
employee of the broker-dealer firm)? Isn’t this a conflict? No. This is because
the fiduciary duties are ordered –
i.e., the fiduciary duty to the client comes first, and any fiduciary duty the
registered representative owes to the broker-dealer firm is secondary.

For example, an attorney
might be an employee of a law firm. The attorney, as an employee of the law
firm, represents the law firm and has a fiduciary duty of loyalty to the law
firm, under general principles of agency. But the individual lawyer also has a
fiduciary duty to the client. If the individual lawyer breaches his or her duty
of loyalty to the client, such as engaging in a prohibited commercial
transaction with the client to further the law firm’s interest (e.g., a commercial transaction in which
the client did not receive independent legal advice before entering into the
transaction with the lawyer), the lawyer is individually liable, and the law
firm is liable as well vicariously, under the doctrine of respondeat superior.

Hence, if and when the
“Definition of Fiduciary” rule is applied by the DOL, it will apply to both the
broker-dealer firm and its registered representatives. This means that, absent
an exemption to the prohibited transaction rules under ERISA (see discussion,
below), revenue-sharing arrangements between the broker-dealer firm and an
asset manager recommended to a plan sponsor are not permitted (unless, if an
exemption is so granted under the new regulations, the fees charged by the
fiduciary broker-dealer are reduced by the amount of the revenue-sharing
received from the asset manager).

I believe it is very unlikely
that revenue-sharing arrangements, so common in the investment industry today,
will continue if the “Definition of Fiduciary” regulation is put into effect.

(3) Will Proprietary Products Be
Available Under the DOL’s Re-Proposed Rule?
A reader ask: If the broker-dealer is affiliated with the asset manager
(i.e., under common ownership, etc.), will the broker-dealer be able to provide
products from that asset manager (i.e., proprietary products)?

Look for an exemption here,
but the scope of the exemption and its conditions are uncertain.

The issue of sales of
proprietary products is a vexing one under fiduciary law. Many states had to
deal with this issue, in their statutes, about 2-3 decades ago, when banks and
their trust companies desired to switch fiduciary “common trust funds” into
bank-owned, proprietary mutual funds. Most states required that the “management
fees” charged by the fund be credited against the separate trustee fees charged
on the account. However, it has become obvious that this “solution” to the
conflict of interest was not perfect. For example, the “administrative fees”
paid to other affiliates of banks (or their holding companies) sometimes far
exceed similar amounts of administrative fees paid by similar-sized,
similarly-managed funds who engage independent third-party firms for services
paid for by such fees.

Even with fee crediting, many
states also require that the proprietary fund recommended be in the best
interests of the client. In practice, according to many trust officers I have
spoken with, this results in recommending only those proprietary funds which
outperform the average of their peers over a specified time frame. (Since
outperformance over any period of time has been shown to be not indicative of
future performance, especially when an adjustment is made for the level of fees
incurred by the fund’s shareholder, the use of such a benchmarking technique is
questionable, in the author’s view).

Australia’s new fiduciary
requirements on its financial services professionals take effect soon.
Australia’s approach is more stringent, when proprietary products are involved:

RG
175.267. In determining the scope of the advice, an advice provider will need
to use their knowledge about a range of strategies, classes of financial
product and specific financial products commonly available and which are
relevant considering the subject matter of the advice sought by the client ….

RG
175.367 An advice provider must prioritise the interests of the client if the
advice provider knows, or reasonably ought to know, when they give the advice
that there is a conflict between the interests of the client and the interests
of:

(a)
the advice provider;

(b)
an associate of the advice provider;

(c)
the advice provider’s [firm]….

RG
175.372 An advice provider cannot comply with the conflicts priority rule
merely by disclosing a conflict of interest or getting the client to consent to
a conflict. [Note: A condition of a contract (or other arrangement) is void if
it seeks to waive any of the obligations in s961J: s960A. Additionally, these
obligations cannot be avoided by any notice or disclaimer provided to the client:
see RG 175.213.] ….

RG
175.379 The conflicts priority rule does not prohibit an advice provider from
accepting remuneration from a source other than the client (e.g. a fee from a
product issuer). However, Div 4 of Pt 7.7A prohibits advice providers from
accepting certain types of remuneration which could reasonably influence the
financial product advice they give or the financial products they recommend to
clients ….

RG
175.380 If an advice provider gives priority to maximising or receiving the non-client
source of remuneration over the interests of the client, the advice provider
will be in breach of the conflicts priority rule ….

RG
175.381 The conflicts priority rule means that:

(a)
an advice provider must not recommend a product or service of a related party
to create extra revenue for themselves, their AFS licensee or the related
party, where additional benefits for the client cannot be demonstrated;

(b)
where an advice provider uses an approved product list that only has products
issued by a related party on it, the advice provider must not recommend a
product on the approved product list, unless a reasonable advice provider would
be satisfied that it is in the client’s interests to recommend a related party
product rather than another product with similar features and costs ….

As seen, the ASIC requires a
“tough test” – the “demonstration” of “additional benefits” for the client.
Yet, in a note to RG 175.381(b), the ASCI also endorses the use of
“benchmarking,” stating: “One way that an advice provider may be able to do
this is by benchmarking the product against the market for similar products to
establish its competitiveness on key criteria such as performance history,
features, fees and risk. The benchmarking must be reasonably representative of
the market for similar products that are offered by a variety of different
issuers.”

Hence, I would expect that,
under the application of ERISA’s tough sole interests standard, we will likely
see a similar result. Three requirements are likely to be imposed by EBSA when
proprietary funds are recommended: (1) management fees earned must be credited
back against other fees charged by the advisor in some fashion; (2)
administrative fees paid to affiliates will receive enhanced scrutiny, to
ensure no “double dipping” occurs; and (3) benchmarking to the entire universe
of similar funds or to broad indexes (not just an index of “actively managed
funds” - as used by Lipper indices, for example) will be required.

I suspect that a trend that
began more than a decade ago – the divestment by broker-dealer firms of their
asset management divisions – will continue. Otherwise, the recommendation of a
proprietary fund will always receive a heightened degree of scrutiny, both by
regulators and plantiffs’ attorneys alike. Additionally, a competition
disadvantage exists when competitors – who don’t utilize proprietary funds –
point out the inherent conflict of interest that exists.

(4) Will ERISA’s Standards Now Apply to IRAs
and to the IRA Rollover Decision?A
reader asks: “Based on the proposed DOL regulations, are 401k-to-IRA rollover
discussions considered a fiduciary conversation? If so, why? If this is the
case, does this make it virtually impossible for any financial advisor to
solicit for rollover business? Why or why not?”

Yes, and yes.

As to the Dept. of Labor and
IRA accounts, under the Internal Revenue Code issue: First, section 4975(e)(3)
of the Internal Revenue Code of 1986, as amended (Code) provides a similar
definition of the term "fiduciary" for purposes of Code section 4975
(IRAs). However, in 1975, shortly after
ERISA was enacted, the Department issued a regulation, at 29 CFR 2510.3-21(c),
that defines the circumstances under which a person renders ``investment
advice'' to an employee benefit plan within the meaning of section 3(21)(A)(ii)
of ERISA. The Department of Treasury issued a virtually identical regulation,
at 26 CFR 54.4975-9(c), that interprets Code section 4975(e)(3). 40 FR 50840
(Oct. 31, 1975). Under section 102 of Reorganization Plan No. 4 of 1978, 5
U.S.C. App. 1 (1996), the authority of the Secretary of the Treasury to interpret
section 4975 of the Code has been transferred, with certain exceptions not here
relevant, to the Secretary of Labor.

Hence, when the DOL/EBSA, as
is expected later this year, issues a re-proposal of its "definition of
fiduciary" regulation, in essence the broad exemptions previously provided
disappear, and virtually any provider of personalized investment advice to a
plan sponsor or plan participant would be a "fiduciary" and subject
to ERISA's strict "sole interests" fiduciary standard and its prohibited
transaction rules.

In its 2010 release, the DOL
sought comment on whether any distribution decision should be subject to a
fiduciary standard. I suspect that the DOL will state, in any re-proposed rule,
that the decision to undertake a distribution, when the decision involves a
transfer of funds into an investment or insurance product, will be subject to
the fiduciary standard of conduct. There is much abuse in this area, already.
For example, one “strategy” which is taught to some financial advisors, and
subsequently deployed with clients (through seminar-based marketing, mainly),
is the withdrawal of funds from IRA and other investment accounts for placement
of the funds in a (nonqualified) Equity Indexed Universal Life Policy. A
dubious technique, considering the high commissions resulting form the sale of
most EIUL policies, and the other limitations and features of such products
(which falls outside of the discussion of this article).

(5) Specifically, How Will the EBSA’s
Re-Proposed Rule Expand the Definition of “Fiduciary”?

We
don’t know for certain what the re-proposed rule will look like, but
commentators largely expect that the 2010 Proposed Rule from EBSA, which
redefined “fiduciary” broadly, will be largely followed. (As discussed below,
certain exemptions will be provided from the definition of “fiduciary,” under
the re-proposed rule.)

Statutory Definition. The definition of fiduciary under ERISA can be found
at Section 3(21)(A). This definition includes parties rendering investment
advice for a direct or indirect fee with respect to plan assets. This statutory
definition appeared very broad.

1975 DOL Regulations. In 1975, the DOL issued regulations interpreting when
offering advice resulted in fiduciary status. The regulations provided a 5-part
test. The 1975 regulations, which remain in effect until any new regulation is
finalized, provide that in order to be deemed a fiduciary as a result of
providing investment advice, the advisor must:

(1)Render advice as to the value of securities or other
property, or make recommendations as to the advisability of investing in,
purchasing or selling securities or other property;

(2)Provide the advice on a regular basis;

(3)Provide the advice pursuant to a mutual agreement,
arrangement or understanding, with the plan or a plan fiduciary;

(4)The advice will serve as a primary basis for
investment decisions with respect to plan assets, and

(5)The advice will be individualized based on the
particular needs of the plan.

The
DOL believed the five-part test was obsolete and the regulations as a whole
needed an overhaul. The retirement plan industry and financial investment
community have changed dramatically since then, especially with the rise of the
401(k) plan, the rapid growth of IRAs, and the increased moving of retirement
money from plan to plan as employees changed jobs more often. Accordingly, EBSA
proposed the new regulations to bring the definition of “fiduciary” in line
with the times.

2010 Proposed Regulation (Now
Withdrawn). Reflecting the tremendous growth of defined
contribution plans (the tremendous growth of 401(k) plans, and the replacement
of most pension plans, was not foreseen when ERISA was adopted), as well as the
tremendous growth in the complexity of investment and insurance products over
the past 35 years, the DOL’s EBSA proposed in 2010 that the definition of
fiduciary, found in the regulation, be significantly expanded.

The
2010 proposed regulation clarified that rendering the advice for a fee included
any direct or indirect fees received by the advisor or an affiliate from any
source, including transaction-based fees such as brokerage, mutual fund or
insurance sales commissions.

Under
the 2010 proposed regulation, fiduciary status under ERISA could then result in
several different ways, which included:

A) Provides
advice or make recommendations pursuant to an agreement, arrangement or
understanding, written or otherwise, with the plan, a plan fiduciary or a plan
participant or beneficiary, where the advice may be considered in making
investment or management decisions with respect to plan assets, and the advice
will be individualized to the needs of the plan, a plan fiduciary or a
participant or beneficiary.

While this language is similar to some of
the language from the old test, there are a couple notable changes. First, the
advice no longer needs to be offered on a regular basis—offering advice on a
single occasion could result in fiduciary status. Second, the advice no longer
need be offered as part of a mutual understanding that the advice will serve as
the primary basis for investment decisions— the advice could be part of several
factors that the plan sponsor considers and still result in fiduciary status.

This would mean that any
investment advice, even provided on a non-continual basis, could lead an
advisor to become subject to ERISA fiduciary obligations. While many
commentators questioned the “expansion” of fiduciary law to cover the provision
of discrete advice, other commentators noted that the test should be whether
advice is provided, not how often; even one-time advice might be instrumental
in a plan sponsor’s or plan participant’s decision-making.

B) Acknowledgement
of fiduciary status for purposes of providing advice.

This provision is significant because
under the old test, a party could acknowledge fiduciary status, and yet still
fail to be held liable if they did not meet all five parts of the old test.

In the 2010 proposed rule, the
EBSA that persons who say they are ERISA fiduciaries are ERISA fiduciaries
irrespective of the nature of the advice provided to a plan, plan fiduciaries,
participants or beneficiaries. This seems entirely logical; it is possible to
contract for an advisor to be a fiduciary (although contracting out of
fiduciary status is largely restricted under fiduciary law). In addition, holding
oneself out as a fiduciary, but not then acting as same, would likely
constitute intentional misrepresentation (i.e., actual fraud). Seems pretty
straight-forward, i.e., “say what you do, do what you say.”

C) Is an investment advisor under Section 202(a)(11) of the Investment Advisors Act of 1940.

D) Provides
advice, appraisals or fairness opinions as to the value of investments,
recommendations as to buying, selling or holding assets, or recommendations as
to the management of securities or other property.

The
DOL noted that part of the intent of this portion of the test is to establish
fiduciary responsibility on parties who provide valuations of closely held
employer securities (such as securities held in ESOP plans) and other hard to
value plan assets.

Reaction to the 2010 Proposed
Regulations. There was a “passionate”
and “robust” response from many segments of the securities and insurance
industry to the EBSA’s 2010 proposed rule. Lobbying was successful in getting
about 100 members of Congress to write to the DOL to question the need for the
rule, the pace of the rule’s enactment, the apparent lack of coordination by
DOL with SEC, or all three of the foregoing.

Yet,
many consumer groups and pro-fiduciary advocates supported the EBSA’s proposed
rule. This author submitted two comments, including one which rebutted many of
the arguments made by Wall Street’s proxies. Seehttp://www.dol.gov/ebsa/pdf/1210-AB32-PH026.pdf.

The DOL Re-Tools. The DOL has engaged economists (both within and
without EBSA) to beef up the economic case for expanding the current definition
of fiduciary. (This economic analysis is to be shared with the SEC, as well).
EBSA has reviewed all of the comments submitted, and any new re-proposed rule
is likely to try to resolve some of the “ambiguities” which some commentators
complained about. In addition, EBSA’s Asst. Sec. of Labor Phyllis Borzi remains
firmly committed to coming out with a re-proposed rule. See http://scholarfp.blogspot.com/2013/03/most-courageous-phyllis-borzi-and-her.html.

(6)
Will There Be Any Exemptions Provided from the Expanded Definition of
Fiduciary?

Let
me preface this by stating that exemptions are often granted to agency rules,
and yet sometimes the unintended (or intended) consequence is that the
exemptions end up “swallowing” the entire rule.
For example, many commentators believe that the “incidental advice”
exemption swallowed the rule for the definition of “investment adviser” under
the Investment Advisers Act of 1940, under subsequent SEC rule-making. Hence,
exemptions must be carefully worded in order to achieve their intended
objective, while still achieving the objective of the main rule itself.

Under
the 2010 proposed regulation, three major exemptions were provided by EBSA from
the definition of “fiduciary”:

The “Seller’s
Exemption.” This exemption was available if recommendations made
in the capacity of a seller or purchaser of a security to a plan or participant
whose interests are adverse to the plan or its participants, provided that the
recipient of the advice or recommendation knows or should have known that the
seller or purchaser was not undertaking to provide impartial investment advice
(this exception would not include an advisor who has acknowledged fiduciary
status).

As stated in the issuing release, “[t]his
provision reflects the Department’s understanding that, in the context of
selling investments to a purchaser, a
seller’s communications with the purchaser may involve advice or recommendations,
within paragraph (c)(1)(i) of the proposal, concerning the investments offered. The Department has determined that such
communications ordinarily should not result in fiduciary status under the
proposal if the purchaser knows of the person’s status as a seller whose
interests are adverse to those of the purchaser, and that the person is not
undertaking to provide impartialinvestment
advice.”

What is interesting about this exemption
is that the DOL was proceeding down a path which the SEC has avoided for decade
– i.e., drawing a line between “advice” and “sales.”

In my opinion, there is certainly a place
for “product sales” – i.e., situations where one is involved in merchandizing
investment products. The key is to
carefully distinguish “merchandizing” from “advice” in a fashion where: (1) if
advice is in fact provided, fiduciary status attaches; (2) if advice is not
provided, and only a description of the product occurs (with no
“recommendation” as to whether the product would be “good” for the customer),
that the customer clearly understand that caveat
emptor (“let the buyer beware”) applies and that the customer cannot and
should not “rely” upon the product provider, other than for an accurate
description of the product itself. In addition, the use of titles and designations which denote an advisory relationship should trigger "advisor" ("fiduciary") status.

The
“Education Provider” Exemption. Providing investment education information and
materials. Many commentators to this aspect of the proposed regulation
questioned how the line between “education” and “advice” would be drawn.

The “Menu of
Products” Exemption. Marketing or making available a menu of investment
alternatives that a plan sponsor may choose from, and providing general
financial information to assist in selecting and monitoring those investments,
provided this is accompanied by a written disclosure that the party is not
providing impartial investment advice.

We do not know how each of
the foregoing exemptions will be modified under any re-proposed rule.

NOTE: The Prohibited Transaction Rules, and
Exemptions Thereto. Over the past two
years Asst. Sec. of Labor Phyllis Borzi has hinted that the re-proposed rule may
include some special exemptions from the prohibited transaction rules where it
is obvious that the participant would benefit from such exemption.

Under ERISA, the term
"prohibited transaction" includes any direct or indirect:

The sale, exchange,
or leasing of any property between a plan and a disqualified person;

The lending of
money or other extension of credit between a plan and a disqualified person;

The furnishing of
goods, services, or facilities between a plan and a disqualified person;

The transfer to,
or use by or for the benefit of a disqualified person, of the income or assets
of a plan;

An act by a
disqualified person who is a fiduciary whereby the fiduciary deals with the
income or the assets of a plan in his own interest or for his own account; or

Receipt of any
consideration by a disqualified person who is a fiduciary from any party
dealing with the plan in connection with a transaction involving the income or
assets of the plan.

These prohibited transaction
rules are contained in both the Internal Revenue Code and in Title I of
ERISA. The labor law provisions also
prohibit fiduciaries from acquiring certain percentages of employer securities
or real property.

Also, under current DOL provisions,
a fiduciary may not (1) deal with plan assets in his own interest, (2) act in
any transaction involving a plan on behalf of a party whose interests are
adverse to the plan's interests or those of the participants or beneficiaries,
and (3) receive any consideration for his own personal account from any party
dealing with the plan in connection with a transaction involving the plan’s
assets.

Unlike the application of the
“best interests” fiduciary standard under state common law and/or the
Investment Advisers Act of 1940, “ERISA’s prohibited transaction rules are
unique in that they are absolute. You can never enter into a non-exempt
prohibited transaction under ERISA, even if conflicts have been fully disclosed
and the client provides its written consent.”
Marcia S. Wagner, Esq., Wagner Law Group, “BASICS OF ERISA” outline,
Oct. 17, 2012, at p. 9, available at http://www.wagnerlawgroup.com/documents/BasicsERISADoc101711_000.pdf.

There already exist various
exemptions from the prohibited transaction rules. However, these exemptions
were granted prior to the EBSA’s 2010 proposed rule. In addition, it should be
noted that ERISA provides that “the Secretary may not grant an exemption under
this subsection unless he finds that such exemption is — (1) administratively
feasible, (2) in the interests of the plan and of its participants and
beneficiaries, and (3) protective of the rights of participants and
beneficiaries of such plan.” 29 USC § 1108(a).

Class exemptions, which
possess broad applicability, have been granted in the past. As explained by
Marcia S. Wagner, Esq.:

The
DOL may grant administrative exemptions allowing a person to engage in a
variety of transactions involving employee benefit plans. DOL administrative
exemptions can come in the form of ‘class exemptions’ that are available to all
persons that can satisfy the applicable conditions, or ‘individual exemptions’
that may only be utilized by the person who requested the exemption.

Class
exemptions are administrative exemptions that permit any person to engage in a
covered transaction with a plan so long as it is done in accordance with the
terms and conditions of the class exemption. Class exemptions typically cover routine
plan transactions that were not foreseen when the statutory exemptions in ERISA
were enacted. For example, DOL class exemptions permit:

•
Investments in mutual funds by a plan when a plan’s investment fiduciary is
also affiliated with the fund’s investment manager (subject to fee-leveling so
that plan fiduciary does not receive ‘double’ compensation and other conditions
of PTE 77-4); and

•
Providing brokerage services for a commission, where the broker-dealer or its
affiliate is also acting as the plan’s investment manager or adviser (subject
to enhanced disclosure requirements and other conditions of PTE 86-128).

“BASICS OF ERISA” at p.12.

Whether these exemptions
would continue under the re-proposed rule is the subject of some discussion.
Can current industry practices survive under a re-proposed rule? This author
thinks that many industry practices will not survive, given the substantial
academic research in support of the proposition that higher fees and costs
imposed upon plan participants and investors result, on average, in lower
returns. Clearly a focus of the EBSA’s disclosure regulations (already adopted)
and its “Definition of Fiduciary” re-proposal is to eliminate the often-hidden
fees and costs incurred by investors.

In essence, ERISA-governed
accounts, and IRA accounts, would be advised upon by “purchaser’s
representatives.” Selling of funds to plan sponsors would still be permitted by
non-fiduciaries (“seller’s representatives), provided they clearly disclosed
their status as such, that they were not providing unbiased advice, and
(hopefully) that they only limit their activities to a description of their
products.

(7) What Should Plan Sponsors Do Now?

The fact is that litigation
against plan sponsors for offering only high-cost, high-fee funds is growing,
even under the current ERISA standards.

It is extraordinarily risky
for a plan sponsor, for a plan of any size, to deal with a financial services
person (or firm) which does not accept full fiduciary obligations. To assist a
plan sponsor (as well as individual investors) in locating a “true fiduciary,”
I have provided guidance in a prior blog post. Seehttp://scholarfp.blogspot.com/2013/05/how-to-choose-financialinvestment.html.

Wednesday, May 22, 2013

American business is the engine which drives forth the
growth of our economy, and delivers prosperity for all. An important component
of the fuel for this engine is monetary capital. Yet, this monetary capital is
not efficiently delivered to the engine of business … it’s as if the engine is
stuck using an outdated, clogged carburetor, in the form of substantial intermediation costs by current investment banking practices.

More importantly, the transmission system of our economic
vehicle is failing, leading to far less progress in our path toward personal
and U.S. economic growth. The transmission system is large, heavy and unwieldy;
its sheer weight slows down our vehicle. It unnecessarily diverts much of the power
delivered by the engine to Wall Street, rather than deliver it to the investors
(our fellow Americans) who provide the monetary capital.

The ramifications of this inefficient vehicle are many, and they are severe. The cost of capital to business is much higher than it should be, due
to the significant intermediation costs of Wall Street in raising capital. And,
because Wall Street currently diverts away from investors 35% or more of the
profits generated by American publicly traded companies, often through high
fees and other hidden fees and costs, investors receive far less a proportion
of the returns of the capital markets.

This all leads to a high level of individual investor distrust in our system of
financial services and in our capital markets. In fact, many individual investors,
upset after discovering the high intermediation costs present, flee the capital
markets altogether. As a result, the capital markets are further deprived of
the capital which fuels American business and economic expansion, and the cost
of capital is again raised. Indeed, as higher levels of distrust of financial
services continue, the long-term viability of adequate capital formation is
threatened.

Even more severe are the long-term impacts of high
intermediation costs imposed by Wall Street firms on investors themselves.
Individual investors, now largely charged with saving and investing for their
own financial futures through 401(k) and other defined contribution retirement
plans and IRA accounts, reap far less a portion of the returns of the capital
markets than they should. These substantially lower returns from the capital invested, due to Wall Street’s
diversion of profits, result in lower reinvestment of the returns by individual investors; this in tern also leads to even lower levels of capital formation
for American business.

As individual Americans’ retirement security is not
adequately provided through their own investment portfolios, saddled with such
high intermediation costs, burdens will shift to governments – federal, state
and local – to provide for the essential needs of our senior citizens in future
years. These burdens will likely become extraordinary, resulting in far greater
government expenditures on social services than would otherwise be necessary.
As a consequence, higher tax rates become inevitable, for both American business and
individual citizens alike.

In essence, American business has become Wall Street’s
servant, rather than its master. The excessive rents extracted at multiple
levels by Wall Street firms fuels excessive bonuses paid, in large part, to
young investment bankers. Wall Street also drains some of the best talent away
from productive businesses, as well. Consequently, Wall Street has become a huge
drain on American business and the U.S. economy, as it derives excessive rents
at the expense of corporations and individuals. The financial services sector, rather than providing the grease for American's economic engine, instead has become a very thick sludge.

There is but one solution to this crisis. The compelling
answer to the problem presented by Wall Street’s excessive growth and
consumption of a 35% or greater share of the profits of American business lies
in the application of the bona fide fiduciary standard of conduct to all
providers of personalized investment advice. Simply put, this broad-based
fiduciary standard requires only that financial advisors act in the best
interests of their clients.

Yet, Wall Street strongly opposes efforts by the U.S.
Department of Labor (Employee Benefits Security Administration) and the U.S.
Securities and Exchange Commission to apply a bona fide fiduciary standard to
the delivery of investment advice to retirement plan sponsors (business
owners), retirement plan participants (employees), and to all Americans. Worse
yet, Wall Street and its proxies – brokerage firms, insurance companies, and securities
industry organizations which oppose the fiduciary standard – seek to have a “new
federal fiduciary standard” adopted which is not a true fiduciary standard at
all, and which would permit Wall Street to continue to extract excessive rents
from the U.S. economy.

By way of explanation, Wall Street will “accept” more
disclosures – provided, of course, they are as general as possible and, as to
details, only provided upon request of the client. Yet, a bona fide fiduciary
standard of conduct requires much more. While disclosure is important, under a
bona fide fiduciary standard of conduct conflicts of interest must be either
avoided or, if not avoided, properly managed. And the proper management of a
conflict of interest requires not just disclosure of the conflict, but also
affirmative disclosure of all of the ramifications of that conflict of interest
in a manner designed to ensure client understanding and to secure client
consent. Even then, the client must not be harmed (for no truly informed client
would ever consent to harm), and the transaction must be substantively fair to
the client. Wall Street resists these requirements with a passion, for it knows
it would be unable to extract excessive rents, as it does currently, if a bona
fide fiduciary standard is applied.

In summary, the bona fide fiduciary standard of conduct is
good for all Americans. More importantly, it is good for, and strongly needed
by, American business. The application of a true fiduciary standard will assist
to restore the much-needed trust in our capital markets, so necessary to foster
capital formation and resulting economic growth. Application of the fiduciary
standard will result in a much larger and more appropriate share of the returns
of the capital markets flowing – not to Wall Street – but instead to investors.

The fiduciary standard of conduct, if applied correctly,
will enhance the retirement security of our fellow Americans, reducing future
burdens on governments, leading to lower tax rates in future years and greater
prosperity for all.

The proper application of the fiduciary standard
to the delivery of investment advice, as is now being considered by the DOL and
SEC, provides an historic opportunity for American business to speak up, demand
adoption and implementation of the bona fide fiduciary standard. In this
manner, American business will foster its own future growth, and greater future
prosperity for business, our fellow Americans, and for America itself.

I call upon American business leaders to speak up, and let policymakers in Washington, D.C. and beyond know of their concerns for adequacy of future capital formation and economic growth. Unite to restore faith in our capital markets. Resolve to rid our economy of the sludge which slows it down so much, in favor of a more efficient engine and transmission which will propel American business to greater prosperity.

Ron A. Rhoades, JD, CFP(r) is an Asst. Prof. of Business at Alfred State College. To follow this blog, please follow him on Twitter (@140ltd) or link to him via LinkedIn. Please direct any questions to RhoadeRA@AlfredState.edu. Thank you.

Another article critical of the arrangement portrayed was posted by Andy Gluck at http://www.advisors4advisors.com.Since these articles came out, the
question has been posed by several readers of this blog: “Can Registered
Investment Advisers (RIAs) receive compensation which is not paid directly by
the client?” The Answer: “Yes, and no.”

And the
following specific question has also been posed: “Can RIAs receive revenue-sharing,
in the form of a portion of 12b-1 fees, from their custodian?” The Answer? “Yes,
and no.” Or, as any good lawyer might opine, “it depends.”

Permit me to first
convey some additional facts about the practice and compensation method under
scrutiny. I then explore the fiduciary of loyalty and what it requires when a
conflict of interest is present. I then return to the fee-sharing arrangement
between the discount broker (custodian) and the independent RIA firm, and seek
to offer an opinion as to whether it is proper.

THE
CASE OF THE “CUSTODIAL SUPPORT
SERVICES AGREEMENT.”

In the
practice under scrutiny, a discount custodian places certain mutual funds on
the custodian’s “no-transaction-fee” platform. The mutual fund company pays the custodian all or part of the 12b-1 fees charged to fund shareholders. This practice in itself is not surprising, as this
has become the more-or-less standard methodology by which no-transaction-fee
funds are offered by discount brokerage firms.

What is surprising, however, is
that the discount broker (custodian) then turned around and shared a portion of
those fees with an otherwise independent RIA firm (i.e., not one associated
with a broker-dealer), under a “custodial support services.”

What services
could an RIA possibly be providing to a large discount brokerage firm
(custodian)? Part 2A of Form ADV, the "Firm Brochure" of PHH
Investments, Ltd. dba Retirement Advisors of America, dated March 2013, states
that under the “custodial support services agreement with Fidelity … the Firm
provides Fidelity with certain back office, administrative, custodial support
and clerical services with respect to Firm accounts (“Support Services”). In
exchange, Fidelity provides certain recordkeeping and operational services to
the Firm, which may include execution, clearance and settlement of securities
transactions, custody of securities and cash balances, and income collections.
Fidelity pays the Firm a fee to defray the Firm’s costs and expenses for
providing these Support Services. The amounts of these payments are calculated
based on the average daily balance of eligible client assets, which consist
primarily of client investments in ‘no transaction fee’ mutual funds. The
Firm’s receipt of this fee may create a potential conflict of interest. It is
the policy of the Firm to place the interest of its clients first, so the
decision to invest or not in a particular mutual fund is not dependent upon
either of these agreements.”

Similar arrangements may have existed for some time with other RIA firms. For example, here's one disclosure which sets forth the amount of compensation provided:

"[RIA FIRM] has entered into a custodial support services agreement with National Financial Services,LLC and Fidelity Brokerage Services, LLC (together with National Financial Services LLC,“Fidelity”) in connection with [FIRM]’s participation in the Fidelity Registered InvestmentAdvisor Group (“FRIAG”) platform. [FIRM] provides back-office, administrative, custodialsupport and clerical services in connection with Client accounts on the FRIAG platform. Forthese services, Fidelity pays [FIRM] the following percentage based upon NFPSI Client assets onthe FRIAG Platform: Assets Percentage $100,000,001 - $150,000,000 0.10% $150,000,001 - $200,000,000 0.11% $200,000,001 - $500,000,000 0.12% $500,000,001 and over 0.14%"[From the Form ADV, Part 2A dated 2005, of an RIA firm.]

The foregoing
Form ADV Part 2 disclosure results in several questions:

Are the Fees Paid Reasonable for the Services Provided? First, what are these “back office, administrative, custodial support and clerical services with respect to Firm accounts” that the RIA firm is providing to Fidelity? What value is the RIA firm providing to Fidelity, that merits Fidelity paying a portion of the 12b-1 fees to the RIA firm?

Is the Disclosure of Material Facts Made to Client Adequate, Explicit, and Understandable? Second, is the disclosure to the clients adequate? Given that I cannot pinpoint or evaluate the services provided, nor the amount of fees paid to the RIA firm, does the disclosure meet the requirement to disclosure all “material facts” with complete candor? Are other point-of-recommendation disclosures undertaken by the RIA firm to the clients, which provide the level of specific disclosure of material facts required under the fiduciary standard of conduct, in a manner designed to ensure complete client understanding?

Has the Client Been Harmed? Third, even with disclosure, is the investment of client funds in no-transaction-fee funds in the client’s best interests? I have previously written about 12b-1 fees, and cautioned RIA firms (and broker-dealers) to avoid them – it is the possible next big scandal to affect the securities industry. Seehttp://scholarfp.blogspot.com/2013/03/12b-1-fees-rias-and-registered.html.

Furthermore, since the
time of my article referred to above, on the issue of 12b-1 fees, the U.S. Court of Appeals for the 9TH Circuit,
in dicta, issued its own warning (applying ERISA’s strict “sole interests” fiduciary
standard), stating: “Mutual funds generate this revenue by charging what is
known as a Rule 12b-1 fee to all investors participating in the fund. Edison
takes the position that because that fee applies to Plan beneficiaries and all
other fund investors alike, the allocation of a portion of that total 12b-1 fee
to Hewitt is irrelevant. As it put the matter at oral argument: ‘the mutual
fund advisor can do whatever it wants with the fees; sometimes they share costs
with service providers who assist them in providing service and sometimes they
don’t.’ This benign-effect, of course, assumes that the ‘cost’ of revenue
sharing is not driving up the fund’s total 12b-1 fee and, in turn, its overall
expense ratio. It also assumes that fiduciaries are not being driven to select
funds because they offer them the financial benefit of revenue sharing. The
former was not explored in this case and the evidence did not bear out the
latter, but we do not wish to be understood as ruling out the possibility that
liability might—on a different record—attach on either of these bases.”

In essence,
the 9th Circuit recognizes that no client would ever provide
informed consent to a conflict of interest where the client would be harmed.
Since substantial academic evidence exists that fees and costs matter, if 12b-1
fees are charged and not credited back to client accounts, is not the client
harmed? In essence, don’t 12b-1 fees nearly always result in a higher overall
expense ratio, with no real benefit to the client of a fiduciary advisor?

One can
hypothesize that small periodic contributions to a no-transaction-fee fund
might be appropriate, to avoid transaction fees and to deploy cash into the
markets cost-effectively. But, even then, a prudent RIA firm would likely
require the client to sell the no-transaction-fee fund once a certain level of
assets was accumulated in same, and purchase a fund without 12b-1 fees instead,
in an effort to keep the client’s fees and costs over time as reasonable as
possible.

UNDERSTANDING
THE FIDUCIARY STANDARD – GENERALLY, IT’S NOT JUST ABOUT DISCLOSURE; MUCH MORE
IS REQUIRED OF THE FIDUCIARY ADVISOR.

A conflict of
interest cannot be dealt with merely by disclosure. A bona fide fiduciary
standard requires much more.

The duty of
loyalty is a duty imposed upon an investment adviser, as the investment adviser
possesses a fiduciary relationship to his or her client. Investment advisers must take only those
actions that are within the best interests of the client. The fiduciary should not act in the
fiduciary’s own interest. Engaging in
self-dealing, misappropriating a client’s assets or opportunities, having
material conflicts of interest, or otherwise profiting in a transaction that is
not substantively or “entirely fair” to the client may give rise breaches of
the duty of loyalty. High standards of
conduct are required when advising on other people’s money.

While the
“best interests” fiduciary standard often permits disclosure of a conflict of
interest followed by the informed consent of the client, it should be noted
that the existence of conflicts of interest, even when they are fully
disclosed, can serve to undermine the fiduciary relationship and the
relationship of trust and confidence with the client. The existence of substantial or numerous
conflicts of interest, which otherwise could have been reasonably avoided by
the investment adviser, could lead to not only an erosion of the investment
adviser’s relationship with the client, but also an erosion of the reputation
of the investment advisory profession. Hence, investment advisers should reasonably act to avoid conflicts of
interest.

Investment
advisers should maintain objectivity and be free of conflicts of interest in
discharging professional responsibilities. Objectivity is a state of mind, a quality that lends value to a member's
services. It is a distinguishing feature of the profession. The principle of objectivity imposes the
obligation to be impartial, intellectually honest, and free of conflicts of
interest. Independence precludes
relationships that may appear to impair a member's objectivity in rendering
investment advice.

Many types of
compensation are permissible under these Investment Adviser Rules of
Professional Conduct, including commissions, a percentage of assets under
management, a flat or retainer fee, hourly fees, or some combination thereof. However, the term “independence” requires
that the investment adviser’s decision is based on the best interests of the
client rather than upon extraneous considerations or influences that would
convert an otherwise valid decision into a faithless act.An investment adviser would not be
independent if the investment adviser is dominated or beholden to or affiliated
with an individual or entity interested in the transaction at issue and is so
under their influence that the investment adviser’s discretion and judgment
would be sterilized. Compensation arrangements which vary the
investment adviser’s compensation depending upon the investment strategy or
products recommended by the investment adviser to the client creates such a
severe conflict of interest that investment advisers should act to reasonably
avoid such arrangements.Let me restate this, to be clear: AVOID DIFFERENTIAL OR VARIABLE COMPENSATION ARRANGEMENTS. It will be most difficult to convince a jury that you, the advisor, were acting in the best interests of your client. And the burden of proof falls upon you, the fiduciary, in an action brought for breach of fiduciary duty.

A conflict of
interest occurs when the personal interests of the investment adviser or the
investment adviser’s firm interferes or could potentially interfere with the
investment adviser’s responsibilities to his, her or its clients. Hence, investment advisers should not accept
inappropriate gifts, favors, entertainment, special accommodations, or other
things of material value that could influence their decision-making or make them
feel beholden to a particular person or firm.

MUST
CONFLICTS OF INTEREST BE AVOIDED UNDER THE FIDUCIARY STANDARD?

Under the
ERISA “sole interests” fiduciary standard and its prohibited transaction rules,
an ERISA fiduciary must nearly always avoid conflicts of interest relating to
compensation.

However, under the Investment Advisers Act of 1940 and state
common law “best interests” fiduciary standard, certain conflicts of interest
are permitted – but provided they are properly
managed. (Yet, as we will see, it is difficult to properly manage conflicts of interest.)

Why is, under the Advisers Act and state common law, disclosure of a conflict of interest (alone, and without more) insufficient to meet one’s fiduciary obligations? This is
because the legal concepts of estoppel and waiver possess a place in anti-fraud
law, generally; however, in the fiduciary
legal environment estoppel and waiver operate differently than that found in
purely commercial relationships. Core
fiduciary duties cannot be waived. Nor
can clients be expected to contract away their core fiduciary rights. Estoppel has a different role in the context
of “actual fraud,” as opposed to its limited role when dealing with
“constructive fraud.” For estoppel to
make unactionable a breach of a fiduciary obligation due to the presence of a
conflict, it is required that the fiduciary undertake a series of measures, far
beyond undertaking mere disclosure of the conflict of interest.

It should be
also noted that the common law rules applicable to fiduciaries also include the
“no profit rule” (part of the commonly referred-to duty of loyalty), which requires a fiduciary not to profit from his position at
the expense of his or her client. At
times the no profit rule has been strictly enforced by courts in different types of fiduciary arrangements, even to the point of
overturning transactions between fiduciaries and their clients where no extra
profit was derived by the fiduciary above that which other market participants
would have derived. in the jurisprudence involving registered investment
advisers, such a strict enforcement has not been undertaken - at least not yet.

WHAT,
SPECIFICALLY, IS REQUIRED TO “PROPERLY MANAGE” A CONFLICT OF INTEREST?

The
jurisprudence of the Investment Advisers Act of 1940 amply illustrates the true
nature of fiduciary obligations. When a
conflict of interest is present, “disclosure” followed by “consent” are, in and
of themselves, wholly insufficient to prevent a breach of fiduciary obligations. Disclosure must occur timely and be of all
material facts. The burden is upon the
investment adviser to reasonably ensure client understanding, and the client’s
“duty to read” is circumscribed. Such
disclosure and achievement of client understanding is fundamental to securing
not just the client’s “consent,” but rather the client’s informed consent. Even then,
the proposed action must remain substantively fair to the client.Breaking this
down into its parts, each part can then be separately examined:

First, disclosure must be affirmatively undertaken of all material facts relating to the conflict of interest and its potential impact on the client.

Second, the informed consent of the client is obtained.

Third, the transaction must remain substantively fair to the client.

Disclosure is Required of All Material
Facts. “Under federal and state law, you are a fiduciary and
must make full disclosure to your clients of all material facts relating to the
advisory relationship.” General
Instructions for Part 2 of Form ADV, #3.
In fact, the SEC requires registered investment advisers to undertake a
broad variety of affirmative disclosures, well beyond disclosures of conflicts
of interest, and many of these disclosures are required to be found in Form
ADV, Parts 1 and 2A and 2B. For example, Part 2A
requires information about the adviser’s range of fees, methods of analysis,
investment strategies and risk of loss, brokerage (including trade aggregation
policies and directed brokerage practices, as well as use of soft dollars),
review of accounts, client referrals and other compensation, disciplinary
history, and financial information, among other matters. (A full listing and discussion of the extent
of these disclosures is beyond the scope of this article.)

SEC Staff also recently noted
that under the “antifraud provisions of the Advisers Act, an investment adviser
must disclose material facts to its clients and prospective clients whenever
the failure to do so would defraud or operate as a fraud or deceit upon any
such person. The adviser’s fiduciary
duty of disclosure is a broad one, and delivery of the adviser’s brochure alone
may not fully satisfy the adviser’s disclosure obligations.” SEC’s “Staff Study on Investment Advisers and
Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act” (Jan. 21, 2011), p.23 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

Furthermore, disclosure must be
undertaken with absolute candor and clarity. As stated by Justice Cardoza: “If
dual interests are to be served, the disclosure to be effective must lay bare
the truth, without ambiguity of reservation, in all its stark significance
….” Wendt
v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926).

The extent of
the disclosure required is made clear by cases applying the fiduciary standard
of conduct in related advisory contexts. “The fact that the client knows of a
conflict is not enough to satisfy the attorney's duty of full disclosure.” In re Src Holding Corp., 364 B.R. 1 (D.
Minn., 2007). "Consent can only
come after consultation — which the rule contemplates as full disclosure....
[I]t is not sufficient that both parties be informed of the fact that the
lawyer is undertaking to represent both of them, but he must explain to them
the nature of the conflict of interest in such detail so that they can understand
the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey
Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) (quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339,
1345-46 (9th Cir.1981)); see also British
Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900
(E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully
inform and obtain consent from the client); Kabi
Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992)
(stating that evidence of the client's constructive knowledge of a conflict
would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp.,
711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent
facts is not sufficient."). A
client of a fiduciary is not responsible for recognizing the conflict and
stating his or her lack of consent in order to avoid waiver. Manoir-Electroalloys,
711 F.Supp. at 195. Rather, “[t]he
lawyer bears the duty to recognize the legal significance of his or her actions
in entering a conflicted situation and fully share that legal significance with
clients.” In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007).

But, having said all of the
foregoing, what is a “material fact”? “When
a stock broker or financial advisor is providing financial or investment
advice, he or she … is required to disclose facts that are material to the
client's decision-making.” Johnson v. John Hancock Funds, No.
M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006). A material
fact is “anything which might affect the (client’s) decision whether or how to
act.” Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va.,
1984). A fact is considered material if
there is a substantial likelihood that a reasonable investor would consider the
information to be important in making an investment decision. TSC Industries, Inc. v. Northway, Inc.,
426 U.S. 438, 449 (1976); Basic, Inc. v.
Levinson, 485 U.S. 224, 233 (1988).

In essence, a material
conflict of interest is always a material fact requiring disclosure. The existence of a conflict of interest is a
material fact that an investment adviser must disclose to its clients because
it "might incline an investment adviser -- consciously or unconsciously --
to render advice that was not disinterested." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 191-192.

Disclosure Must be
Adequately Undertaken.

“The [SEC}
Staff believes that it is the firm’s responsibility—not the customers’—to
reasonably ensure that any material conflicts of interest are fully, fairly and
clearly disclosed so that investors may fully understand them.” SEC’s “Staff Study on Investment Advisers and
Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act” (Jan. 21, 2011), p.117 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)

As stated in an
early case applying the Advisers Act:
“It is not enough that one who acts as an admitted fiduciary proclaim
that he or she stands ever ready to divulge material facts to the ones whose
interests she is being paid to protect. Some knowledge is prerequisite to
intelligent questioning. This is particularly true in the securities field.
Readiness and willingness to disclose are not equivalent to disclosure. The
statutes and rules discussed above make it unlawful to omit to state material
facts irrespective of alleged (or proven) willingness or readiness to supply
that which has been omitted.” Hughes v.
SEC, 174 F.2d 969 (D.C. Cir., 1949).

Disclosure Must Be
Sufficient to Obtain Client “Understanding.”
As stated in an early decision by the U.S. Securities and Exchange
Commission: “[We] may point out that no hard and fast rule can be set down as
to an appropriate method for registrant to disclose the fact that she proposes
to deal on her own account. The method and extent of disclosure depends upon
the particular client involved. The investor who is not familiar with the
practices of the securities business requires a more extensive explanation than
the informed investor. The explanation must be such, however, that the
particular client is clearly advised and understands before the completion of
each transaction that registrant proposes to sell her own securities.” In re
the Matter of Arleen Hughes, SEC Release No. 4048 (1948).

Even
with Informed Consent, the Proposed Transaction Must Be Fair and Reasonable to
the Client. “One
of the most stringent precepts in the law is that a fiduciary shall not engage
in self-dealing and when he is so charged, his actions will be scrutinized most
carefully. When a fiduciary engages in self-dealing, there is inevitably a
conflict of interest: as fiduciary he is bound to secure the greatest advantage
for the beneficiaries; yet to do so might work to his personal disadvantage.
Because of the conflict inherent in such transaction, it is voidable by the
beneficiaries unless they have consented. Even then, it is voidable if the
fiduciary fails to disclose material facts which he knew or should have known,
if he used the influence of his position to induce the consent or if
the transaction was not in all respects fair and reasonable.” [Emphasis added.] Birnbaum
v. Birnbaum, 117 A.D.2d 409, 503 N.Y.S.2d 451 (N.Y.A.D. 4 Dept., 1986).

WHY
CONFLICTS OF INTEREST SHOULD BE
AVOIDED.

Regardless of
whether conflicts of interest are permitted under federal securities law for
RIAs, or under state common law, there is both early authority and recent
academic research indicating that investment advisers, to truly act in the best interests of their client, should avoid
conflicts of interest to the extent reasonable to do so:

“[T]he Committee Reports indicate a desire to ... eliminate conflicts of interest between the investment adviser and the clients as safeguards both to 'unsophisticated investors' and to 'bona fide investment counsel.' The [IAA] thus reflects a ... congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested.”SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-2 (1963).

“The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'” Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. 3/30/2007) (D.C. Cir., 2007), citing SEC vs. Capital Gains at 187.

“The temptation of self-interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.”Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844).

“Conflicts of interest can lead experts to give biased and corrupt advice.Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects.First, people generally do not discount advice from biased advisors as much as they should, even when advisors’ conflicts of interest are honestly disclosed.Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. As a result, disclosure may fail to solve the problems created by conflicts of interest and may sometimes even make matters worse.”Cain, Daylian M., Loewenstein, George, and Moore, Don A., “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest” (2003).

These cases leave open the possibility that most conflicts of interest are prohibited for RIAs operating under state common law and the Investment Advisers Act of 1940. The purpose of avoiding conflicts of interest is, without a doubt, to maintain the complete objectivity of the investment adviser, and to avoid the conflict of interest even unconsciously affecting his or her judgment.

IN
CONCLUSION, ARE THE ACTIONS OF THE RIA FIRMS DEFENSIBLE?

Without
knowledge of all of the facts behind these “custodial support services” arrangements,
it is impossible to know if the existence of these “custodial services support agreements”
and the sharing of revenues by discount brokers to RIA firm arising from these
agreements causes harm to the client.

It is easy to suspect that the practice of paying 12b-1 fees to the RIA firm is not in accord with the RIA firm's fiduciary duty. The services provided by the firm do not appear to be of the type which would result in each client who bears the burden of such fee receiving a benefit in accordance with the payment of such "extra" 12b-1 fees.

However, I cannot rush to judgment. More facts are required.Unfortunately, Jed Horowitz may have uncovered just the tip of a very dark and ugly iceberg. Many RIA firms possess insurance agency affiliates, and often the investment adviser representatives recommend the purchase of costly life insurance and annuity products.Moreover, In the world of dual registrants (i.e., where RIAs are jointly licensed as broker-dealer firms, or have an affiliated broker-dealer firm) many more pervasive conflicts of interest exist. Just look at this disclosure, found in a large dual registrant's Form ADV, Part 2:

"Some of our Advisors may participate in incentive trips and receive other forms of non-cash compensation based on the amount of their sales through NFPSI, affiliated marketing groups or nonaffiliated marketing groups or product manufacturers. To the extent your Advisor participates in an incentive trip or receives other forms of non-cash compensation, a conflict of interest exists in connection with the Advisor’s recommendation of products and services for which they receive these additional economic benefits."

(There is no discussion in the Form ADV from which the above paragraph was taken as to how such conflict of interest was properly managed, to keep the best interests of the client paramount. Presumably such discussion is lacking because proper management of such an insidious conflict of interest was not even possible.)
The fact of the matter is, many firms - especially dual registrants - don't believe that the fiduciary duty to avoid conflicts of interest, or to properly manage conflicts of interest, is all that important. Many believe that once a conflict of interest is disclosed, that such disclosure provides a license to the advisor to engage in conduct which harms the client. Of course, nothing could be further from the truth.

We have a long way to go to create a profession. Especially as Wall Street and the insurance companies continue their assault on the SEC and DOL/EBSA, to not proceed with the application of fiduciary duties by regulation. (Alternatively, they desire a "new federal fiduciary standard" that involves disclosure only.)

In the meantime, I hope that a
reader of this blog post will forward more information about these "custodial support service" arrangements
to me (E-mail: RhoadeRA@AlfredState.edu),
so that I can then provide an informed opinion on this matter.

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About the Author

Ron A. Rhoades, JD, CFP® sailed across the Atlantic on a tall ship, performed in theme parks and road shows in Europe and America as a Disney character, rowed on a championship crew team, marched in the Macy’s Thanksgiving Day Parade, marched in competition with a state-champion rifle drill team, undertook a solo one-week trip into the Everglades, escorted numerous celebrities around Central Florida, performed as a “Tin Man” at a mountaintop theme park called “The Land of Oz” in Beech Mountain, NC, and served as a stage manager and talent scheduling coordinator for entertainment productions at Walt Disney World. And then he graduated college.

Since then, Ron Rhoades earned his Juris Doctor degree, with honors, from the University of Florida College of Law, which was preceded by a B.S.B.A. from Florida Southern College. Ron Rhoades has 30 years of experience as an attorney, with nearly all of those years substantially devoted to estate planning, tax planning, and retirement plan distribution planning. Ron also has over 15 years as a personal financial adviser. He was a principal with an investment advisory firm where he served as its Director of Research and Chair of its Investment Committee.

The author of numerous articles published in financial industry publications and several books, Dr. Rhoades has been quoted in numerous consumer and trade publications, and has been interviewed on Bloomberg's "Masters in Business" radio show segment. He writes occasional articles for industry publications. Ron is a frequent speaker at local FPA chapter meetings and national conferences in the financial planning and investment advisory professions.

Ron Rhoades was the recipient of The Tamar Frankel Fiduciary of the Year Award for 2011, from The Committee for the Fiduciary Standard, as he “altered the course of the fiduciary discussion in Washington.” He was also named as one of the Top 25 Most Influential persons associated with the investment advisory profession in 2011 by Investment Advisor magazine, and was voted to the “Sweet 16 Most Influential” in Wealth Management’s 2013 “March Madness” competition. Dr. Rhoades was also named as one of the "Top 30 Most Influential" members in NAPFA's 30-year history in 2013. This blog was also called one of the "Top 25 Most Dangerous" in financial services.

Ron A. Rhoades, JD, CFP® became Program Director for the Financial Planning Program (B.S. Finance, Financial Planning Track) at Western Kentucky University's Gordon Ford School of Business in July 2015. He provides instruction to highly motivated, exceptional undergraduates students in such courses as Applied Investments, Retirement Planning, Estate Planning, and the Personal Financial Planning Capstone course. He has previously taught courses in Insurance & Risk Management, Employee Benefits, Money & Banking, Advanced Investments, and Business Law I and II.

Ron also serves on the Steering Committee of The Committee for the Fiduciary Standard, on whose behalf he frequently travels to Washington, D.C. to meet with policy makers in Congress and in government agencies regarding the application of the fiduciary standard to personalized investment advice.